If the early policy response to the pandemic has gone relatively smoothly in terms of averting a liquidity crisis, its next phase might pose more challenges. Most immediately, there is the question of DSSI extension. At their October 2020 meeting, G20 finance ministers and central bank governors moved to extend by six months, to the end of June 2021, the window for debt service relief under the DSSI, with the possibility of a further six-month extension after that. This decision was subsequently endorsed by G20 leaders at the November summit.
However, any liquidity problems that last for over a year are likely to morph into solvency problems, especially if full economic reopening is delayed by the slower distribution of vaccines expected in most emerging markets and developing countries. Indeed, this risk was explicitly acknowledged by the G20 leaders in their 2020 summit declaration: ‘Given the scale of the COVID-19 crisis, the significant debt vulnerabilities and deteriorating outlook in many low-income countries, we recognize that debt treatments beyond the DSSI may be required on a case-by-case basis.’
There is also growing political unease among policymakers and discontent from civil society at the lack of comparable debt service relief from private sector creditors, despite explicit expectations from the G20 that private creditors should provide appropriate assistance. The reason for this, however, is not foot-dragging by private creditors, who have consistently expressed their support for the DSSI and willingness to participate in the scheme, but rather a lack of requests from DSSI-eligible borrowers. This in turns comes from such countries’ realization that by seeking even temporary debt service relief from private creditors, they will likely suffer credit rating downgrades and adversely impact their ability to access capital markets in the future – with negative implications for both the scale and cost of financing available to them. In other words, the borrowers themselves see more downsides than upsides to approaching private creditors for debt service suspension.
This situation is unlikely to change. Although some commentators interpreted Côte d’Ivoire’s successful return to the capital markets in November, after previously receiving DSSI relief from official creditors, as validation that fears over market access were misplaced, it is in fact hard to draw such a conclusion. The key distinction is that such fears are associated with seeking DSSI relief from private creditors, which Côte d’Ivoire refrained from doing.
In some emerging markets and developing countries, though probably not many, issues of debt sustainability will need to be confronted. The growth shock caused by the pandemic has pushed a handful of countries with pre-existing debt problems into seeking debt restructuring: namely, at the time of writing, Angola, Argentina, Chad, Ecuador, Ethiopia, Lebanon and Zambia. Recession has also increased the number of countries in outright debt distress or at risk thereof. More than 50 per cent of low-income countries are now assessed to be at high risk of or in debt distress, according to the Joint IMF-World Bank Debt Sustainability Framework for Low-Income Countries.
Private creditors are ready and willing to engage in debt restructurings, where required, to restore solvency in these countries. But there are other complications. In many of the debtor countries, there is less than full transparency regarding the amounts owed, the terms of the debt, and the identities of the creditors. In many, if not most, cases, China is a large creditor. But China is not a member of the so-called Paris Club of official creditors, which historically has played a key role in coordinating official-sector creditors in sovereign debt restructurings. In this context the creation of a Common Framework for Debt Treatments beyond the DSSI, adopted by the G20 leaders at their November summit, is an important step forward, because it will facilitate having all the key creditors at the table.
What will remain will be the need for political consensus internationally on using this framework before solvency problems become too large, and with adequate safeguards to ensure that solvency is restored in a sustainable way. That another round of large-scale debt relief for the poorest countries is likely to be necessary 25 years after the launch of the Heavily Indebted Poor Countries (HIPC) Initiative suggests there are lessons still to be learned. In addition, the IMF has identified areas in which contractual debt provisions could be further strengthened to facilitate restructuring.
That another round of large-scale debt relief for the poorest countries is likely to be necessary 25 years after the launch of the Heavily Indebted Poor Countries Initiative suggests there are lessons still to be learned.
A more novel issue is the prospect of monetary policy normalization, in particular the timing and management of a future exit from QE in emerging markets. While enhanced policy cooperation between fiscal and monetary authorities in response to COVID-19 has been as beneficial in emerging markets as it has been in developed ones, the questions around how to unwind current extraordinary measures are likely to bite sooner and harder in emerging markets. As long as inflation is depressed and economies are operating well below full potential, it makes sense for governments and central banks to act in concert, as when central banks engage in QE by buying government debt on secondary bond markets. This allows governments to finance temporary spikes in their spending without triggering a rise in interest rates, which would tighten financial conditions for the entire economy and lead to even lower levels of activity and inflation.
However, as soon as inflationary pressures reappear, this unity of approach becomes harder to sustain. An independent central bank would need to remove some of its support to the economy even if the government concerned still wanted to issue more debt than the markets were prepared to finance. If the central bank failed to act pre-emptively, its inflation-fighting credibility could come into doubt, causing the local currency to depreciate and interest rates to rise anyway. If, on the other hand, the central bank did rein in its QE purchases while government debt issuance was still high, the interest rate required by the market would also go up.
Beyond domestically driven developments, interest rates on emerging-market debt will in any case also go up once interest rates start rising in developed markets. This, combined with much higher debt-to-GDP ratios post-COVID-19, could quickly create unsustainable debt dynamics. Even where fundamentals remain relatively sound, the mere change in sentiment could be damaging, with fears of a debt crisis potentially becoming self-fulfilling.
The US Fed’s adoption of average inflation targeting – announced in August 2020 and likely to be emulated in less explicit fashion by other developed-market central banks – means we are probably a long way away from higher policy rates. This is because the regime shift will allow central banks to be more patient in the face of inflationary pressures before tightening policy.
That said, the timing of QE tapering is already a conversation topic among financial market actors and observers, and as long as growth is seen as healthy the Fed and its peers may not mind letting longer-dated bond yields rise. At the time of writing in late January, the US 10-year government bond was already yielding twice as much as it had at its 2020 trough. Thus, while the moment of reckoning for interest rates may not be just around the corner, it will come for sure. When this happens, countries that have not yet taken decisive steps to reduce their debt burdens may face a ‘taper tantrum’ event, with a sudden drying up of market liquidity leading to a sharp rise in their borrowing costs, potentially turning a hitherto sustainable debt into an unsustainable one. This could also happen sooner in countries where central banks that are struggling to escape fiscal dominance let inflation expectations get out of hand, triggering large-scale currency depreciation. While central banks in both developed and emerging markets are equally exposed to these risks in theory, in practice those in the latter are much more vulnerable, owing to less entrenched disinflationary pressures and weaker inflation-fighting credibility.